Can we save retirement?

What the US and other countries can learn about social security reform

Credit: Matt Chase

Alex Verkhivker | Feb 08, 2017

On the website of the interest group that represents American retirees, there’s palpable concern about the future. The vast majority of Americans haven’t saved enough in their retirement accounts to cover their expenses after they finish working. Rising health-care costs and increasing life expectancies only aggravate the problem. And the state pension is a hot political issue. Exactly one month after the US Presidential election, Representative Sam Johnson introduced a bill that would address a looming shortfall in Social Security, the massive federal pension program, by cutting benefits.

“Social Security is a contract with American workers that must not be broken,” read an article on AARP.org a few days later. “AARP will continue its fight to ensure that current and future generations get the benefits they’ve earned.” More than a hundred people quickly weighed in with comments, and hundreds more followed. “When contacting our representatives, we must state clearly and strongly that there will be NO changes to these systems as we know them—except to strengthen them AS IS,” wrote one commenter.

When it comes to pension crises, American workers are not alone. In the United Kingdom, many of the country’s almost 6,000 employer-sponsored, defined-benefit programs are underfunded. “There is a clear economic imperative to address the issues identified, for the health of both individuals and the wider economy,” wrote the Pension and Lifetime Savings Association in an October 2016 report. Doing nothing to fix the problems, it warns, “is not an option.” In Greece, Poland, and across the European continent, a demographic mismatch means there are not enough incoming taxes to fund promised payouts. “Western European governments are close to bankruptcy because of the pension time bomb,” Ernst & Young’s Roy Stockell told the Wall Street Journal last year.

Last year 53 percent of US retirees had less than $25,000 saved, and 27 percent had less than $1,000, according to the Employee Benefit Research Institute.

Privatization is often suggested as a solution to pension crises. Rather than have governments or employers fund workers’ retirements, why not give retirees more control over funding their retirements, with private individual accounts? States and companies are burdened by their promised obligations, but workers planning ahead could save more and choose how much risk to take when investing their retirement funds.

Some countries have adopted aspects of this privatized model, and researchers are analyzing the results. Evidence from Mexico, Australia, and the United States has lessons for countries facing pension crises—and seeking solutions.   

Privatized retirement in Mexico

Many critics of privatization are quick to point to Chile as a cautionary tale. The Chilean government privatized its pension system in 1980, its secretary of labor and social security inspired by Milton Friedman’s book Capitalism and Freedom. But as payouts fell dramatically, upwards of 100,000 people took to the streets last year to demand reform, and President Michelle Bachelet announced a series of changes. 

Less attention has been paid to Mexico, which privatized its system more than a decade later, in 1997. After the 1994 financial crisis, when the peso dropped in value as inflation took off, rescuers that included the World Bank recommended Mexico reform its social-security program. Brown University’s Justine Hastings, University of Chicago’s Ali Hortaçsu, and Chicago Booth’s Chad Syverson analyzed the data to learn from Mexico’s experience with privatization.

In Mexico, money is automatically deducted from workers’ wages and placed in individual accounts. Then individuals choose from a menu of assets in which to invest and work through regulated, professional money managers, each of which offers a single investment product. For the first decade of the system, those managers charged fees on both automatic salary contributions (loads) and assets under management (balance fees). 

“The Mexican government was smart about some elements of the way they designed this system,” says Syverson. For example, the government took steps to create a competitive marketplace, accepting applications from two dozen managers to compete by presumably offering the best prices. With competition among fund managers, many politicians, financial institutions, and even academics predicted rising returns. “Estimates indicate that within 25 years, the reform could double financial savings in Mexico,” wrote Agustín G. Carstens, then director general at Banco de México’s Department of Economic Research, in 1997. 

But competition did not materialize as the government had hoped it would. Hastings, Hortaçsu, and Syverson looked at where investors lived, which fund managers they invested with, how much money they saved—and earned after fees. They find that while many people expected competition to drive down costs, the average asset-weighted load was a steep 23 percent, and balance fees were another 0.63 percent. Those fees ate away—a lot—at returns.  If an investor deposited 100 pesos and earned a 5 percent annual return, “it would take them about six years to get back to their original 100-peso contribution,” says Syverson. “When you add it all up, they would have been better off just burying [their deposit] in a hole for several years.” 

The competition conundrum 

The fund managers did compete, the researchers find, but not by offering the best fees. Instead they competed by offering the slickest marketing, and investors eschewed the cheapest offerings in favor of companies that invested in advertising and sales forces.

Analyzing the content of more than 200 video advertisements for fund managers that ran from 1997 to 1999, the researchers found that fewer than 20 percent said anything about costs. Television spots and sales-force practices focused on selling managers’ experience, innovation, and skill. Problematically, advertising claims were often misleading. The Spanish banking giant Banco Santander, for instance, advertised that it was free to sign up for a retirement account with the bank—without mentioning that this is true for all account managers in Mexico’s system. Another company claimed in an ad illustrated with apples that it wouldn’t “take a bite” out of savings because it charged no fee on contributions, despite charging approximately 4.75 percent of assets under management.

In Mexico, most investors overpaid
Charging higher fees and investing in marketing and sales forces, fund managers lured many people into expensive plans.

Mexico made several reforms in an attempt to bring down fees. One made it easier for investors to switch from one manager to another, but that didn’t do much for fees, as investors weren’t focusing on them anyway.

Another attempted to attack investors’ lack of focus on cost. The government introduced an index intended to allow investors to more easily compare fund managers’ fees. It required that fund managers show a standardized table of comparative fees that boiled loads and asset fees into one more-digestible fee that would make it easier to comparison shop. But investors still bought high-fee funds, according to Brown’s Hastings and RAND Corporation’s Fabian Duarte.  

The government required fund managers to show combined load and balance fees according to a formula that was simple to read but, crucially, didn’t reflect true costs. Investors did pay attention to the index, and many did switch their investment choices in an attempt to invest more wisely. However, management companies restructured their fees to exploit the formula. They lowered load fees but raised management fees to maintain a low index value. As a result, many investors ended up in funds that were more expensive than they realized, and managers continued raking in hefty profits.  

The new fee structure actually raised management costs for low-wage workers, who ended up subsidizing wealthier workers, according to Hastings and Duarte. “Rather than harnessing perfect competition, privatized social safety net markets may result in abundant advertising or complicated and obfuscated fee schedules,” they write. 

Financial-literacy programs for low-income workers would help, according to a model created by Hastings, Hortaçsu, and Syverson. Combining those with a low-cost government alternative that would give the private-fund managers some additional competition could force down prices by as much as 77 percent, the researchers estimate. 

“Our study not only helps explain experiences and outcomes in one of the world’s largest privatized social security markets, but also suggests broader lessons as retirement savings and health-insurance markets head toward greater individual control,” Hastings, Hortaçsu, and Syverson write. 

Mandated savings in Australia

Mexico’s experience offers one cautionary tale, and Australia’s offers another, although somewhat more hopeful. “Australia’s retirement income system is regarded by some as among the best in the world,” writes Julie Agnew of the College of William and Mary. “It has achieved high individual saving rates and broad coverage at reasonably low cost to the government.”

In 1992, Australia recognized its own retirement savings system was inadequate, and its leaders embraced savings and optional matching employer contributions. It kept a government-funded pension safety net, introduced in 1908, but it also required that almost all workers participate in a retirement savings system. Most plans are privately operated. 

A survey of Australian investors found a low level of financial literacy. Over half of respondents either didn’t know what a balanced mutual fund was or incorrectly thought it was composed of risk-free assets. 

Australia’s “Superannuation” system relies on employers, rather than workers, to fund retirement accounts. It has higher minimum savings requirements: currently, employers must contribute 9.5 percent of most workers’ earnings to tax-advantaged retirement plans. That’s 3 percent more than the automatic set-aside required in Mexico. Unlike in the US
and Mexico, early withdrawals are not permitted in the Australian system. 

But Australia, too, has high fees. Workers in Australia are allowed to invest their retirement accounts in a wide variety of assets, and some are expensive. “Many researchers argue that these fees are too high overall,” says Susan Thorp, at the University of Sydney. The average fee is about 1 percent of assets per year, which includes life- and permanent-disability-insurance premiums. One rule of thumb says that an annual charge of 1 percent each year over a 40-year career is equivalent to roughly a 20 percent front load. 

Also, a survey of Australian investors found a low level of financial literacy. Over half of respondents either didn’t know what a balanced mutual fund was or incorrectly thought it was composed of risk-free assets. “This finding is disturbing, as the majority of default investment options at the time of the survey were balanced mutual funds, and suggests more should be done to help Australians understand their financial options,” Agnew writes.

But Australia’s Superannuation program now holds more than A$2 trillion, the equivalent of US$1.5 trillion. That represents almost a third of the roughly $5 trillion saved in the US in 401(k) accounts—and the US has a population roughly 15 times larger. 

The US retirement crisis 

The American retirement system, the world’s biggest, is in trouble. But does the US itself hold lessons for reform? Since the 1980s, saving and investing for retirement in the US has increasingly become the responsibility of individuals. Companies have done away with corporate pensions, and workers have been encouraged to save in tax-advantaged accounts such as 401(k)s and individual retirement accounts. 

Analysis from JP Morgan Asset Management, looking at average investor stock market returns between 1996 and 2015, set against an 8.2 percent annual gain in the S&P 500 during that time, found the rank-and-file investor realized a mere 2.1 percent. Fees ate away at gains, and individuals tossed out some of the rest by pulling counterproductive moves that locked in losses and forewent gains. Behavioral biases cause people to flee the stock market after a plunge, as in 2009, and pile into stocks near a peak, as in 2006.

Now many Americans cannot depend on savings and investments alone to comfortably pay for retirement: 53 percent of US retirees had savings of less than $25,000 in 2016, while 27 percent had less than $1,000 saved, according to the independent Employee Benefit Research Institute (EBRI). Among Americans still working, 54 percent have less than $25,000 in savings, the EBRI reports. (The EBRI excluded primary home and pension values from the savings calculations.)

As for Social Security, it is projected to start running a deficit, and future retirees could receive only partial benefits. In 1983, the US made changes that included gradually raising qualifying full retirement ages from 65 to 67, with the aim of extending the life of the program. The bill put forward by Johnson, chairman of the House Ways and Means Social Security subcommittee, would again raise the retirement age (to 69) and cut benefits for many. 

US politicians have broached the idea of giving individuals further control over Social Security. In his 2005 State of the Union address, former US President George W. Bush proposed letting some workers redirect a portion of their social-security withholding into individual accounts. Bush remarked:

Personal accounts are a better deal: your money will grow, over time, at a greater rate than anything the current system can deliver. And your account will provide money for retirement over and above the check you will receive from Social Security.

Some research findings at the time indicated reason for concern about the plan. Nobel Prize–winning economist Peter A. Diamond of MIT, and the Brookings Institution’s Peter R. Orszag, examined three proposals presented by Bush’s Commission to Strengthen Social Security, and found significant risks in all, particularly associated with cash flow. To finance Bush’s privatization proposals, the shortfall in funds entering the Social Security system would have to be made up by borrowing, increasing the federal debt. Individual accounts “are simply inappropriate for a social insurance system intended to provide for the basic tier of income during retirement, disability, and other times of need,” they wrote, collecting their thoughts in the book Saving Social Security: A Balanced Approach. 

Bush’s proposal failed to advance, and it remains to be seen whether individual accounts would gain traction now. But the experiences of reform suggests that privatization involves nuance. Fees can be high, despite considerable efforts to promote competition. Mandated savings levels can be set too low. “To the extent policymakers care about the total costs paid to operate a system, it may be necessary to do more than simply set up a market with several players and free information flows,” write Hastings, Hortaçsu, and Syverson. A privatized market involves a range of thorny details—all of which matter to the many millions of people moving daily toward retirement.